ELA - Price Elasticity of Demand Lesson
Price Elasticity of Demand Lesson
Elasticity is a concept that refers to the sensitivity of one variable to changes in another variable.
Price Elasticity of Demand
The Law of Demand tells us that price impacts the quantity demanded by consumers. Specifically, it recognizes that price and quantity demanded are negatively related. The concept of price elasticity of demand indicates the degree to which quantity demanded changes in response to a change in price.
Price Elasticity of Demand
Generalization about demand curves: If the two extremes (perfectly elastic and perfectly inelastic) result in horizontal and vertical curves, then we can draw the following conclusion. A flatter demand curve implies a greater degree of elasticity and a steeper demand curve implies less elasticity.
Factors That Determine Price Elasticity of Demand
Availability of Substitutes: Goods and services with adequate available substitutes tend to be more elastic as price rises. This is because consumers can drastically reduce the quantity demanded of the good as its price rises and purchase the substitutes instead.
Urgency of Need: If the purchase of an item can be postponed, demand will be more elastic in response to a price increase. If the purchase cannot be delayed, the demand will be less elastic.
Portion of Income: Goods that take up a large portion of income tend to be more sensitive to price changes and are more elastic. Small ticket items are less responsive to changes in price and are less elastic.
General v. Specific Market: A general market like "food" tends to be less elastic when price rises. A specific market like "steaks" tends to be more elastic. This is because, as prices rise, we can reduce our consumption of steaks quite a bit (elastic demand), but we can't reduce our consumption of food in general very much (inelastic demand).
Necessity v. Luxury: Items that are considered necessities tend to have less elastic demand. Luxury items will have a greater degree of response to price changes and tend to be more elastic.
In general, demand for all goods tends to be more elastic over the course of the long run, as consumers will have time to search out suitable alternatives, etc..
As you can see, a great deal of subjectivity exists when trying to evaluate the price elasticity of demand by considering these factors. The factors are important because they help to understand the reason why the quantity demanded of some goods are more sensitive to price changes compared to other goods. However, there are numerical interpretations for determining the price elasticity of demand.
Elasticity Video
Watch the video below for examples of the factors that impact price elasticity of demand. To make the video full screen, click the double arrows at the bottom right corner of the object.
Formula
The formula for the price elasticity of demand is a ratio of the percentage change in quantity relative to the percentage change in price. Remember, the law of demand tells us that price and quantity demanded are negatively related. This means the value of Ed would always be negative. Because the negative sign only represents the relationship between price and quantity identified in the Law of Demand and tells us nothing about the elasticity (responsiveness), you must take the absolute value of Ed.
Sometimes, the percentage changes will be given and simple division will yield the value for Ed. For instance, a scenario may identify that the price of Good X increased by 40% and the quantity demanded decreased by 22%. In this scenario, you would do the following:
In analyzing the parts of this equation, note that the change in price of 40% produced a 22% decrease in the quantity demanded. Thinking back on the categories given for elasticity, recall that a good is price inelastic if the percentage change in price produces a relatively smaller percentage change in quantity demanded. Here, the price change of 40% produced a 22% decrease in quantity (which is relatively smaller). Therefore, this good is price inelastic.
In other cases, the information may require additional work before it can be solved. For example, you may be given two data sets containing prices and quantities. In this instance, it is appropriate to use the midpoint formula for calculating the price elasticity of demand. This ensures that no matter which direction price is changing (from $2.00 to $3.00 or from $3.00 to $2.00), everyone will arrive at the same value for Ed. In this case, you would assign one set of data to be P1 and Q1 and the other data set to be P2 and Q2.
Price Elasticity Interactive Practice
Solve the problem. Then click to see if your solution is correct.
The Scale for Price Elasticity of Demand
Ed > 1 = Elastic
Ed = 1 = Unit (Unitary) Elastic
Ed < 1 = Inelastic
Ed = ∞ = Perfectly Elastic (this occurs when the %Δ in price is 0)
Ed = 0 = Perfectly Inelastic (this occurs when the %Δ in quantity is 0)
The Total Revenue Test
Since changes in price can have varying degrees of effects on the quantity demanded of a good or service, total revenue can be used to determine the price elasticity of demand. Total revenue (or total sales or total receipts) is the money generated in sales for a good. It is found by multiplying price and quantity sold. That is, TR = P x Q.
To use total revenue to determine the price elasticity of demand, you should compare how revenue changes when price changes. The rules are found below:
- A good is considered elastic when price changes and total revenue changes in the opposite direction. ↑P ↓TR or ↓P ↑TR
- A good is considered unit elastic when price changes and total revenue does not change.
- A good is considered inelastic when price changes and total revenue changes in the same direction. ↑P ↑TR or ↓P ↓TR
The Total Revenue Test Interactive Practice
Solve the problem. Then click to see if your solution is correct.
Price Elasticity of Demand and Total Revenue for Linear Demand Curves
Any downward sloping, linear demand curve will exhibit all three types of elasticity.
Looking at the graph on the right, you should notice a typical negatively sloped demand curve. The negative slope of the demand curve reflects the fact that price must be lowered to induce consumers to buy more of the product. An additional curve has been added to the top graph. It is the marginal revenue curve. Marginal revenue is the additional revenue generated by selling one more unit of a good. It lies below the demand curve to reflect that marginal revenue will always be less than price (which is found on the demand curve) when dealing with a negatively sloped demand curve. Why is marginal revenue less than price? To sell more, the price must be lowered, but it is not lowered only on the additional units it wants to sell. Rather, the price is lowered on all previous units, too. For all linear, negatively sloped demand curves, the marginal revenue curve will intersect the x-axis exactly halfway between the origin and the x-intercept of the demand curve.
Marginal revenue can be positive, zero, or negative. Since marginal revenue is the change in total revenue, TR will increase when MR is positive, peak when MR equals zero, and begin to decrease when MR is negative. Across the range of quantities that coincide with a positive marginal revenue, total revenue is increasing as the price of the good is decreasing. Keep in mind that the total revenue test determined a good is elastic when price and total revenue move in opposite directions. Over this range of quantities, the demand for the good is price elastic.
As the price of the good continues to decrease and the quantity sold continues to increase, marginal revenue will eventually intersect the x-axis and become negative. Once the marginal revenue curve becomes negative, total revenue decreases. Over this range of quantities, the demand for the good becomes price inelastic (price and TR are moving in the same direction).
The significance of marginal revenue's x-intercept is that it corresponds to the point on the demand curve that represents unit elasticity. That is, it splits the demand curve into two pieces. The upper portion is the elastic portion with Ed values greater than 1. The lower portion is the inelastic portion with Ed values less than 1. What separates numbers greater than 1 from numbers less than 1? The number 1! Remember, unit elastic demand equals 1. Therefore, the unit elastic point separates the ranges of elasticity on the curve.
Elasticity of Demand Video
The video below provides a nice summary of the major points regarding price elasticity. To make the video full screen, click the double arrows at the bottom right corner of the object.
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